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NOVUM May 2015
Size matters small is beautiful The impact of Portfolio
Diversification and Selection on Risk and Return in Private
Equity
A research study* conducted by Prof Oliver Gottschalg (HEC Paris
and PERACS) and Dr Ralf Gleisberg and Ramun Derungs (Akina).
*The comprehensive research study can be requested by contacting
Dr Ralf Gleisberg ([email protected])
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Executive Summary
- Optimally diversified small/mid-cap portfolio is superior in
terms of return and risk
- Small/mid-cap funds consistently outperform large-cap
portfolios (both in EU and in the US)
- Strong (risk-reducing) effect of diversification
- Optimally diversified portfolio contains about 15 funds
- Positive effect of selection both on return and risk
- European portfolios with broader return dispersion than North
American portfolios
Introduction / Data / Methodology
Private equity has become in the current low interest
environment an increasingly popular component of investors
portfolios. Yet many investors still struggle how to best implement
their allocation to the private equity asset class. Investors need
to take decisions shaping the design of their private equity
portfolio, including choices about the number of funds, geographic
focus and size of such funds. There is not much reliable evidence
on how these choices influence the risk/return characteristics of
the corresponding portfolio.
The research is based on a comprehensive data set of 771 mature
European and North American primary buyout funds covering fund
vintage years from 1998-2007 and is provided by Preqin. 1000 random
portfolios are created using Monte Carlo simulation methods. Such
portfolios consist of 1, 5, 10, 15, 20, 25, 30, 50 or 100
underlying fund(s). This approach is first applied to the overall
data set and then to specific sub-samples e.g. selection ability,
geographic focus and market size.
For each of these portfolios, we then calculate the average
return of all underlying funds, as well as the return dispersion.
The latter is calculated in two ways. First, we use the traditional
approach of measuring the range of observed portfolio returns
between the minimum and the maximum portfolio returns. Second, we
apply a more advanced approach to graphically capture and quantify
the portfolio return dispersion using a novel technique developed
by PERACS.
Optimally diversified portfolio contains about 15 funds
Our findings point to an optimally diversified portfolio of
about 15 funds. With this portfolio size the diversification effect
comes already into play. While the range between the best and worst
possible outcome of 1000 simulated portfolios with a single
underlying fund goes from 0.02x to 6x, already a diversification
across 15 primary funds reduces this range to [1.2x, 2.6x].
PERACS Risk curve overall diversification effect
Positive (risk-reducing) effect of diversification Decreasing
marginal diversification effect (of increasingly large portfolios)
Decreasing risk coefficient with increasing portfolio size
0x
1x
2x
3x
4x
5x
6x
7x
1 5 10 15 20 25 30 50 100
TVP
I
Number of underlying funds in portfolio
Average portfolio return & return dispersion
Average
6.0x
0.02x
2.6x
1.2x
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Positive effect of selection on both return and risk
Overall, investors fund selection ability has an obvious impact
on the average performance. We observe that the performance of the
worst portfolio of above-average funds is higher than the average
return of portfolios consisting of below-average funds. Selection
skills show therefore a quite strong risk-reducing effect. However,
not only selection ability reduces risk also diversification is
beneficial from a risk perspective e.g. the worst upper portfolio
performance improves from 1.52x to 1.80x through
diversification.
Selection ability has (not surprisingly) an huge impact on the
average performance Worst upper portfolio returns more than the
average of lower portfolios (e.g. 1.52x vs. 1.21x) Worst upper
portfolio performance improves from 1.52x to 1.80x through
diversification
European portfolios with broader return dispersion than North
American portfolios
The average returns of the primary funds in the subsamples from
Europe and North America are very similar. However, the dispersion
of returns is greater across European funds than for the North
American peers allowing the European funds to outperform. Adding
further funds to the portfolio leads not only to a convergence of
the worst performing European to the North American portfolios but
also results in higher best performing portfolios of European
funds. For instance, increasing the number of underlying primary
funds to 15 increases the bottom portfolio to 1.26x in both
regions. However, the best performing portfolio is meaningfully
higher in Europe than in North America (2.47x vs. 2.36x).
Higher return dispersion in European funds Best performing
portfolios in Europe Convergence of the worst performing European
to US-portfolios through diversification
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Size matters Small/mid-cap portfolios outperform large-cap
portfolios
Large-cap funds substantially underperform portfolios made up of
mid-cap and in particular of small-cap funds. We observe a related
trend when it comes to performance dispersion. Large-cap funds have
a lower return dispersion than small-cap funds.
Small/mid-cap portfolios outperform large-cap portfolios (e.g.
1.73x vs. 1.66x) and show a higher return dispersion Increasing
diversification leads to over-proportionate risk mitigating effect
in small/mid-cap funds
An asset allocation decision
In practice, investors face resource and volume limitations
related to how much money they can invest in small/mid-cap funds.
Therefore, they need to prioritise between two investment
approaches: either fewer large funds or more smaller funds.
Consider as an illustrative example first a portfolio made up of
five commitments of $45 million each to funds in the large-cap
category and second a portfolio made up of 15 commitments of $15
million each to funds in the small- and mid-cap category.
While both strategies deployed a total of $225 billion, the
expected average returns of the large-cap case are of 1.66x,
compared to average returns of the small/mid-cap strategy of 1.72x
(or 1.82x in a pure small-cap portfolio). At the same time, the
small/mid-cap strategy is also preferable from a risk standpoint,
as the worst possible outcome of 1000 portfolios favours also the
small/mid-cap strategy (1.27x vs. 0.97x). Taken together, our
results indicate that a optimally diversified small/mid-cap
strategy is likely to be superior in terms of risk and (!) return
to a concentrated large-cap strategy.
Small/mid-cap portfolio is superior in terms of return and
risk
Optimally diversified small/mid-cap portfolios outperform
concentrated large-cap strategy and is less riskier
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The above mentioned results left us wondering whether the
superiority of an optimally diversified small/mid-cap portfolio is
specific to funds of a certain return category. So we replicated
the analysis separately for subsamples of funds with above- and
below-average returns. Interestingly, our results illustrate that
indeed this particular relationship seems to be specific to the
better performing funds. In case an investors selection ability is
below-average a concentrated portfolio of few large funds is
superior in terms of the average return. However, from risk
perspective a diversified small/mid-cap portfolio looks still more
favourable.
Selection skills lead to stronger outperformance and lower
risk
Optimally diversified small/mid-cap strategy leads to
outperformance with more favourable bottom performance despite
having a similar return dispersion.
The results of the research get confirmed when looking at
European funds only. An optimally diversified European
small/mid-cap portfolio is less risky than a concentrated European
large-cap portfolio and performs better in terms of both average
and peak returns.
Looking at Europe only
Optimally diversified European small/mid-cap portfolio is not
only (slightly) less risky but performs better both on average
(2.27x vs. 1.92x) and with superior peak performance (3.11x vs.
2.48x)
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About the authors of the study
Professor Oliver Gottschalg HEC Paris, PERACS T:+33 670 01 76 64
E: [email protected]
Prof Oliver Gottschalg current research focuses on the strategic
logic and the performance determinants of private equity
investments. His work has been published in leading academic
journals and in various publications for practitioners. In parallel
to his faculty position at HEC, he is affiliated with INSEAD as a
visiting researcher and the coordinator of the HEC Buyout Research
program. He holds a Wirtschaftsingenieur Diploma from the
University of Karlsruhe, an MBA from Georgia State University and a
M.Sc. and Ph.D. degree from INSEAD.
Dr Ralf Gleisberg Akina Ltd T: +41 44 220 16 08 E:
[email protected]
Dr Ralf Gleisberg is a Partner of Akina. He is responsible for
advising on fund investments in the Benelux and the Nordic
countries. He is member of the advisory board of several private
equity funds across Europe. In addition, Ralf has been instrumental
in setting up the portfolio monitoring for Akina advised investment
vehicles. He holds a Masters Degree in Economics from the
University of Freiburg (D) and from the University of Michigan at
Ann Arbor (USA) and a Ph.D. degree in Finance from Basel University
(CH).
Ramun Derungs Akina Ltd T: +41 44 220 16 20 E:
[email protected]
Ramun Derungs joined Akina in March 2014 as an Associate. His
main responsibilities are to provide support to the marketing and
investor relations front staff. He holds a Master of Science in
Banking & Finance from the Zurich University of Applied
Sciences.
About Akina The Akina Group offers European private equity funds
focusing on investing into small and medium size businesses through
its alternative investment manager, Akina (Luxembourg) S.A. and its
adviser, Akina Ltd. Since 1999, the Euro Choice flagship programmes
and mandates have attracted over EUR 2.0 billion (USD 2.1 billion)
from well over 100 qualified investors around the globe. The Akina
team combines a broad fund and direct investment expertise. Akina
was awarded the Gold Award (2011) and the Silver Award (2012, 2013
and 2014) for best regional investment strategy by Private Equity
Exchange & Awards. Akina (Luxembourg) S.A. is an alternative
investment fund manager (AIFM) registered with the Luxembourg
Commission de Surveillance du Secteur Financier (CSSF). Akina Ltd
is an investment adviser registered with the U.S. Securities and
Exchange Commission (SEC). Akina is a signatory to the Principles
for Responsible Investment (PRI). www.akinapartners.com
